The accrual basis of accounting entails the recording of revenue and expenditure on the date when a particular transaction occurs, even if the payment is yet to be completed. For instance, if company A has purchased goods on credit from company B on February 10, 2024, and the payment is to be made a month later, the transaction would be recorded in both companies’ books on February 10, 2024, rather than on the date when the payment is completed. Amongst the pivotal elements of accrual accounting is the accrued interest.
In this article, we shall discuss the meaning of accrued interest and how it is treated in accounting.
What is accrued interest?
In accounting, accrued interest refers to the amount of interest that has been incurred, as of a specific date, on a loan or other financial obligation but has not yet been paid out. Accrued interest can either be in the form of accrued interest revenue, for the lender, or accrued interest expense, for the borrower.
Depending on whether you are the buyer or seller (or debtor or creditor) in a transaction, accrued interest could be an asset or liability for you. Another common form of accrued interest is accrued interest on investment; that is, interest that has become due but is yet to be paid. Now that we have discussed the meaning of accrued interest, let us turn our attention to how accrued interest is generated.
Accounting is done for a specific period, usually a month and, in turn, a financial year. Interest outstanding on a particular obligation is computed as of the last date of the aforementioned period. However, the actual date of interest payment may differ depending on various factors, such as the terms of credit (in case of purchase and sale transactions) and the fixed date of interest payment (in case of bonds). Let us understand this with the help of an example.
Company A has to pay interest on an outstanding loan on the 15th of each month. The accounting period followed by the company, however, is 1st to 31st. The interest outstanding for a particular month shall be paid out on the 15th of the following month, but the total interest accrued for the said month shall be recorded in the books of accounts on the 30th/ 31st of the month. Interest for 15 days will be treated as accrued interest. The same concept is applicable to interest that is receivable by a company.
How is accrued interest treated in accounting?
The accrued interest for any particular period is recorded in the books of account, right from the journal to the statement of profit and loss and the balance sheet. Accrued interest due to be paid/ received by a company is recorded in the journal as an adjusting entry. For outstanding interest, there is a journal entry debiting the Interest Expense account and crediting the Accrued Interest Payable account. To record receivable interest, the Accrued Interest Receivable account is debited, and the Interest Revenue account is credited.
In the income statement of a company, accrued interest is recorded as an outstanding expense if it is to be paid and as an outstanding revenue if it is to be received. For the balance sheet, Accrued Interest Receivable is treated and recorded as a Current Asset (since accrued interest is usually for a period lower than one year), and Accrued Interest Payable is recorded as a Current Liability.
Additional read: What are Assets
Example of accrued interest
Let us understand how accrued interest is recorded in the account books through an example. Let us assume Company P has taken a loan of Rs. 12 lakh from Bank X at 10% per annum. The monthly instalments for the aforementioned loan is due on the 5th of each month. For the accounting period of any subsequent month (once the loan repayment begins), the total interest due shall be Rs. 10,000 and accrued interest shall be Rs. 8,333 (considering 30 days in a month).
What is accrued interest on bonds?
The concept of accrued interest is also applicable to investments. Therefore, when you purchase or sell a bond, the transaction amount shall be computed after taking into account the accrued interest on the investment. The interest on bonds is usually paid out on a yearly or bi-annual basis. If a bond is purchased within two interest payouts, the purchaser must add the accrued interest on the bond to the amount to be paid to the seller. This is done because the interest on the bond prior to the date of purchase is owed to the previous owner of the instrument.
Additional read: Capital Adequacy Ratio
Example of accrued interest on bonds
Let us understand how interest accrued on bonds is treated in the event of the sale of a bond. A purchases a bond with a face value of Rs. 1 lakh and 10% fixed annual interest from B on July 1, 2023. The interest for the bond is paid out on December 31. B is entitled to accrued interest from January 1, 2024, to June 30, 2024. The accrued interest for six months, that is, Rs. 5,000, shall be added to the purchase amount, and A will have to pay Rs. 1,05,000 to B for the purchase of the bond and the accrued interest. On December 31, 2024, B shall receive interest on the bond for the entire year (Rs. 10,000).
To sum it up
Accrued interest is an integral element of the accrual concept of accounting. Not only is it important from a transparency and full disclosure point of view, but it is also essential to comply with the revenue recognition concept and matching principle of accounting. By recording accrued interest in its books of accounts (both payable and receivable), a business can ensure that all transactions are being recorded as per the timeline of their occurrence, irrespective of when the payment is settled. Understanding the concept, workings, and accounting treatment of accrued interest is pivotal for modern-day businesses and their various stakeholders.
